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  • 8/14/2019 Advance Accounting Ebook - Part 7.pdf

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    AdvancedAccountingE

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    Discussion topics

    How to analyze a company?

    Analytical techniques for Financial Statement Analysis

    Horizontal Analysis

    Trend Analysis

    Vertical Analysis

    Ratio Analysis

    Solvency

    Current Ratio /Quick Ratio / Cash ratio

    Receivables turnover / Inventory turnover / Payables turnover / Cash Conversion Cycle

    Operating

    Operating Efficiency ratios

    Operating Profitability

    DuPont Formula

    Extended DuPont Formula

    Risk

    Business Risk

    Financial risk

    External liquidity risk

    Growth

    Limitations of Financial Ratios

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    How to analyze a company?

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    Analytical techniques for FSA

    Purpose of Financial Statement Analysis is to evaluate management performance in

    Profitability

    Efficiency

    Risk

    Although financial statement information is historical, it is used to project future performance

    An Analyst is expected to do a complete synthesis using all three methods

    Which method is theBest?

    Horizontaland TrendAnalysis

    Compares two financial statements to determine dollar andpercentage changes

    Compute dollar changes and percentage changes

    VerticalAnalysis

    Shows relationship of each item to a base amount on financialstatements

    Income statement (each item expressed as percentage of netsales)

    Balance sheet (each item expressed as percentage of totalassets)

    RatioAnalysis

    Puts numbers in perspective with other numbers

    Helps control for different sizes of firms

    Ratios provide meaningful relationships between individualvalues in the financial statements

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    Horizontal / Trend / Vertical Analysis

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    Horizontal Analysis

    Horizontal analysis shows the changes between years in the financial data in both dollarand percentage form

    Horizontal analysis on the income statement

    Horizontal analysis can also be done on the liabilities or shareholders equity

    [Current year Base year] /

    [Base year]

    Why provision for tax hasincreased by 12.6%, while therevenues increased by only 5.5%?

    Why there is an increase of 9.1%in Selling and administrative cost?

    GKSR Income Statement 2006 2007 Increase ($) % YoY change

    Rental Operations 801,240 847,401 46,161 5.8%

    Direct Sales 79,603 82,141 2,538 3.2%

    Net Revenues $880,843 $929,542 $48,699 5.5%

    Cost of rental operations (518,543) (541,392) (22,849) 4.4%

    Cost of direct sales (57,522) (59,579) (2,057) 3.6%

    Selling and administrative costs (186,652) (203,614) (16,962) 9.1%

    Operating Expenses ($762,717) ($804,585) ($41,868) 5.5%

    -

    Ebitda $118,126 $124,957 $6,831 5.8%

    Depreciation (32,479) (34,789) (2,310) 7.1%

    Amortization of intangibles (10,784) (10,806) (22) 0.2%

    Ebit $74,863 $79,362 $4,499 6.0%

    Interest Expense (13,226) (13,901) (675) 5.1%

    Income before income taxes $61,637 $65,461 $3,824 6.2%

    Provision for taxes (19,786) (22,271) (2,485) 12.6%

    PAT $41,851 $43,190 $1,339 3.2%

    Basic EPS $1.98 $2.03 $0.05 2.5%

    Diluted EPS $1.97 $2.02 $0.05 2.4%

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    Trend Analysis

    Trend percentages state several years financial data in terms of a base year, which equals100%

    In the example below, we have taken base year as 2002

    We can use the trend percentages to construct a graph so we can see the trend over time

    [Current year ] / [Base year] * 100

    While Operating cost has increasedby 42% since 2002, Net income

    grew marginally by 13% during thecorresponding period

    Income Statement 2002 2003 2004 2005 2006 2007

    Net Revenues 677,591 705,588 733,447 788,775 880,843 929,542

    Operating Expenses 565,077 598,974 625,064 674,566 762,717 804,585

    PAT 38,267 33,689 35,384 38,179 41,851 43,190

    Trend Analysis 2002 2003 2004 2005 2006 2007

    Net Revenues 100.0% 104.1% 108.2% 116.4% 130.0% 137.2%

    Operating Expenses 100.0% 106.0% 110.6% 119.4% 135.0% 142.4%

    PAT 100.0% 88.0% 92.5% 99.8% 109.4% 112.9%

    60%

    80%

    100%

    120%

    140%

    160%

    2002 2003 2004 2005 2006 2007

    Trend Analysis

    Ne t Re ve nues Op eratin g Expense Ne t In co me

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    Vertical Analysis

    Common-size statements use percentages to express the relationship of individualcomponents to a total within a single period is known as Vertical Analysis

    Income Statement (as a percentage of Total Revenues)

    Balance Sheet (As a percentage of Total Asset / Total Liabilities)

    Vertical Analysis 2002 2003 2004 2005 2006 2007

    Rental Operations 96.8% 96.6% 96.6% 93.9% 91.0% 91.2%

    Alcohol 3.2% 3.4% 3.4% 6.1% 9.0% 8.8%

    Net Revenues 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%

    Cost of rental operations -59.5% -60.5% -61.1% -59.6% -58.9% -58.2%

    Cost of direct sales -2.3% -2.5% -2.6% -4.5% -6.5% -6.4%

    Selling and administrative costs -21.6% -21.9% -21.5% -21.4% -21.2% -21.9%

    Operating Expenses -83.4% -84.9% -85.2% -85.5% -86.6% -86.6%

    Ebitda 16.6% 15.1% 14.8% 14.5% 13.4% 13.4%

    Depreciation -4.4% -4.3% -4.3% -4.1% -3.7% -3.7%

    Amortization of intangibles -0.9% -1.0% -1.1% -1.2% -1.2% -1.2%Ebit 11.3% 9.8% 9.4% 9.2% 8.5% 8.5%

    Interest Expense -2.0% -1.9% -1.6% -1.4% -1.5% -1.5%

    Income before income taxes 9.3% 7.8% 7.8% 7.8% 7.0% 7.0%

    Provision for taxes -3.7% -3.1% -3.0% -2.9% -2.2% -2.4%

    PAT 5.6% 4.8% 4.8% 4.8% 4.8% 4.6%

    Since 2004, cost of rentals havedecreased

    EBITDA/EBIT/PAT margins aconcern - continuously

    decreasing trend

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    Ratio Analysis

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    Ratio Analysis

    Ratios can often be more informative that raw numbers

    Puts numbers in perspective with other numbers

    Helps control for different sizes of firms

    Ratios provide meaningful relationships between individual values in the financial statements

    Ratios can be used to evaluate four different areas of companys performance and conditions

    Ratio

    Analysis

    SolvencyRatios

    Current/Cash/Quick Ratio

    TurnoverRatios

    OperatingPerformance

    OperatingEfficiency

    OperatingProfitability

    Risk Analysis

    BusinessRisk

    FinancialRisk

    Externalliquidity risk

    Growth

    Sustainablegrowth rate

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    Ratio Analysis - Solvency

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    Ratio Analysis - Solvency

    Analyst employ these ratios to determine the firms ability to pay its short-term liabilities

    Current Ratio examines current assets and current liabilities

    Higher the current ratio, more likely is that the company will be able to pay its short-term bills

    A ratio of less than 1, means that the company has negative working capital and is probably facingliquidity crisis

    Quick Ratio adjusts current assets by removing less liquid assets

    More stringent measure of liquidity

    Higher the quick ratio, more likely is that the company will be able to pay its short-term bills

    Cash ratio relates cash (ultimate liquid asset) to current liabilities

    Higher the cash ratio, more likely is that the company will be able to pay its short-term bills

    sLiabilitieCurrent

    AssetsCurrentRatioCurrent

    sLiabilitieCurrent

    sReceivableSecuritiesMarketableCashRatioQuick

    sLiabilitieCurrent

    SecuritiesMarketableCashRatioCash

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    Ratio Analysis - Solvency

    Receivables turnover examines the management of accounts receivable

    Balance sheet items are taken as average of the account

    Average collection period is the average number of days it takes for the companyscustomer to pay their bills

    It is desirable to have a collections period closer to the industry norm

    Collection period too high mean that customers are too slow in paying their bills, which implies too muchcapital is tied up in assets

    Inventory turnover measures firms efficiency with respect to its processing and inventorymanagement

    Balance sheet items are taken as average of the account

    Given the turnover values, you can compute the average inventory processing time

    It is desirable to have a collections period closer to the industry norm

    sReceivableAverage

    SalesAnnualNetTurnoversReceivable

    TurnoversReceivable

    365PeriodCollectionsReceivableAverage

    InventoryAverage

    SoldGoodsofCostTurnoverInventory

    TurnoverInventory

    365PeriodProcessingInventoryAverage

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    Evaluating Solvency Ratios

    Payables turnover measures the use of trade credit by the firm

    Balance sheet items are taken as average of the account

    Given the turnover values, we can compute the average payment period processing time

    It is desirable to have a collections payment closer to the industry norm

    Cash Conversion Cycle

    Combines information from the receivables turnover, inventory turnover, and accounts payable turnover

    High conversion cycle is undesirable

    Too high conversion cycle implies that company has excessive amount of capital investment in the salesprocess

    PayablesAverage

    soldgoodsofCostTurnoverPayables

    TurnoverPayable

    365

    PeriodPaymentAverage

    Cash Con Cycle Receivable period Inventory period= + Payable period-

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    Ratio Analysis Operating

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    Ratio Analysis Operating Efficiency

    Operating Efficiency Ratios

    Examines how management uses its assets to generate sales and it considers the relationship betweenvarious asset categories and sales

    Total Asset Turnover ratio indicates effectiveness of a firms use of its total asset base toproduce sales

    Different types of industries have different asset turnovers. Infrastructure business are capital intensiveand may have Asset Turnover closer to 1, however, retail business might have turnover ratios in doubledigits

    Low asset turnover may mean that the company has to much capital tied up in its asset base

    Net Fixed Asset turnover reflects utilization of fixed assets

    This number can look temporarily bad if the firm has recently added greatly to its capacity in anticipationof future sales

    Equity Turnover measures the employment of owners capital

    Equity capital includes all preferred and common stock, paid-in capital and retained earnings

    AssetsNetTotalAverage

    SalesNet

    TurnoverAssetTotal

    AssetsFixedNetAverage

    SalesNetTurnoverAssetFixed

    EquityAverage

    SalesNetTurnoverEquity

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    Ratio Analysis Operating Profitability

    Operating profitability ratios

    Examines how management is doing at controlling costs so that a large proportion of the sales dollar isconverted into profit

    What proportion of the sales dollar is left after cost of goods sold?

    Is the firm buying inputs (inventory and direct labor) at good prices?

    Gross Profit Margin

    Gross profit margin measures the rate of return after cost of goods sold

    Operating Profit Margin

    Operating profit margin measures the rate of profit on sales after operating expenses

    Operating income can be thought of as the bottom line from operations

    Net Margin

    Shows the combined effect of operating profitability and the firms financing decisions (since net income isafter interest and tax payments)

    SalesNetProfitGrossMarginProfitGross

    SalesNet

    ProfitOperatingMarginProfitOperating

    SalesNet

    IncomeNetMarginProfitNet

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    Ratio Analysis Operating Profitability

    Example: Operating Ratios

    Income Statement 2007

    Sales $18,000

    COGS $13,200

    Selling and Admin expenses $3,400

    Interest income $800

    Interest expense $500

    Gain on sale of long term inves $1,200

    Provision for income taxes $1,015

    Selected Balance Sheet items 2007

    Book value of total assets $44,000

    Accumulated depreciation ($12,000)

    Net total assets $32,000

    Shareholder's Equity 22000

    Calculate the following

    a) Operating Profit Margin

    b) Net profit Margin

    c) Asset Turnoverd) Equity Turnover

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    Ratio Analysis Operating Profitability

    Return on total capital relates the firms earnings to all capital invested in the business

    This number should not be too low as compared to the industry average

    We should consider Gross interest expense in our calculation

    Return on total equity indicates the rate of return earned on the capital provided by thestockholders after paying for all other capital used

    Total Equity includes preferred stock

    Return on owners equity is based only on the common shareholders equity

    Preferred dividends are deducted from Net Income as they are a priority claim

    CapitalTotalAverage

    ExpenseInterestIncomeNetCapitalTotalonReturn

    EquityTotalAverage

    IncomeNetEquityTotalonReturn

    EquityCommonAverage

    DividendPreferred-IncomeNetEquitysOwner'onReturn

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    Ratio Analysis Operating Profitability

    DuPont System divides ROE into several ratios that collectively equal ROE while individually

    providing insight

    Most important term in ratio analysis

    Basic algebra for ROE breakdown

    Extended DuPont System

    Provides additional insights into the effect of financial leverage on the firm and pinpoints the effect ofincome taxes on ROE

    We begin with the operating profit margin (EBIT divided by sales) and introduce additionalratios to derive an ROE value

    EquityCommon

    IncomeNetROE

    EquityCommon

    AssetsTotal

    AssetsTotal

    Sales

    Sales

    IncomeNet

    EquityCommon

    IncomeNet

    Profit margin Asset Turnover Financial Leverage

    EquityCommon

    AssetsTotal

    AssetsTotal

    Sales

    Sales

    IncomeNet

    EquityCommon

    IncomeNet

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    Ratio Analysis Operating Profitability

    Extended DuPont Analysis

    Financial leverage involves acquiring assets with funds at a fixed rate of interest

    If Return on Investment in Asset > Fixed rate of borrowing = Positive financial leverage

    If Return on Investment in Asset < Fixed rate of borrowing = Negative financial leverage

    t)-1(EquityCommon

    AssetsTotal

    AssetsTotal

    Sales

    Sales

    EBT

    EquityCommon

    IncomeNet

    t)-1(EquityCommon

    AssetsTotal

    AssetsTotal

    ExpenseInterest

    AssetsTotal

    Sales

    Sales

    EBIT

    EquityCommon

    IncomeNet

    Op. Profit Margin Asset Turnover Interest exp. rate Financial leverage Tax retention rate

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    Ratio Analysis Operating Profitability

    Example : DuPont Analysis

    Please evaluate the following ratios for Pratts company

    2006 2007

    Pre-interest profit margin (EBIT/S) 0.15 0.10

    Asset turnover (S/A) 1.00 1.50

    Leverage (A/E) 2.00 2.50

    Tax retention (1-t) 0.70 0.70

    Interest expense ratio (I/A) 0.05 0.05

    Comment on the firm's ROE trends

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    Ratio Analysis Risk

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    Ratio Analysis Risk

    Risk analysis examines the uncertainty of income for the firm and for an investor

    Total firm risks can be decomposed into three basic sources 1) Business risk 2) FinancialRisk 3) External Liquidity Risk

    Business Risk

    Function of Business variability, Sales variability and Operating leverage

    Between five to ten years of data should be used for calculating business and sales variability

    Also critical is the measure of how much companys production costs are fixed (as opposed to variable)

    Greater the use of fixed costs, greater the impact of a change in sales on the operating income of acompany and hence, higher is the risk

    incomeoperatingMeanincome)(operatingDeviationStandardtyvariabiliBusiness

    salesMean

    (sales)DeviationStandardtyvariabiliSales

    Salesinchange%

    EarningsOperatinginchange%leverageOperating

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    Ratio Analysis Financial Risk

    Financial risk

    The added uncertainty in a firms net income resulting from a firms financing decisions (primarily throughemploying leverage)

    Interest payments are deducted before we get to net income and these are fixed obligations. Similar tofixed production costs, these lead to larger earnings during good times, and lower earnings during abusiness decline

    The use of debt financing increases financial risk and possibility of default while increasing profitabilitywhen sales are high

    Two sets of financial ratios help measure financial risk

    Balance sheet ratios

    Earnings or cash flow available to pay fixed financial charges

    Balance Sheet Ratios

    How much debt does the firm employ in relation to its use of equity?

    How much debt does the firm employ in relation to all long-term sources of funds?

    Assessment of overall debt load, including short-term

    equitytermLong

    debttermLongratioequityDebt to

    capitaltermlongTotal

    debttermLongcapitalTotalDebt to

    EquityTotalDebtTotal

    debttermLongsliabilitieCurrentRatioDebt

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    Ratio Analysis Financial Risk

    Earnings/Cash flow ratios

    Relate operating income (EBIT) to fixed payments required from debt obligations

    Higher ratio means lower risk

    Interest coverageratio determines the firms ability to repay its debt obligations

    Cash flow to long term debt ratiodetermines the ability of the firm to meet its long term debt throughits cash flows

    expenseInterest

    EBITcoverageInterest

    leaseoperatingofPVdebttermlongofBook value

    CFOdebttermlongtoflowCash

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    Ratio Analysis External Liquidity Risk

    External liquidity risk

    External market liquidity is a source of risk to investors

    Market Liquidity is the ability to buy or sell an asset quickly with little price change from a priortransaction assuming no new information

    The most important factor of external market liquidity is the dollar value of shares traded

    This can be estimated from the total market value of outstanding securities

    It will be affected by the number of security owners

    Numerous buyers and sellers provide liquidity

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    Ratio Analysis Example

    Example : Ratio Analysis

    Please evaluate the following ratios

    2006 2007

    Cash Ratio 0.84 0.60

    Operating Profit Margin 30% 36%

    Current Ratio 1.80 1.44

    Total Debt-to-Total Capital Ratio 78% 74%

    Cash Flow-to-Total Debt Ratio 66 60

    Cash Conversion Cycle (days) 54 60Interest coverage 3.00 2.40

    Net Profit Margin 10% 8%

    Debt-to-Equity Ratio 132% 127%

    Comment on the firm's trends on the following

    a) Profitability

    b) Liquidity

    c) Financial Risk (Coverage)

    d) Financial Risk (Leverage)

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    Ratio Analysis Growth

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    Ratio Analysis Growth

    Growth is important to both creditors and owners

    Creditors interested in ability to pay future obligations

    For owners, the value of a firm depends on its future growth in earnings, cash flow, and dividends

    If the company doesnt grow, it stands a much greater chance of defaulting on its loans

    Sustainable growth rate is a function of two variables:

    What is the rate of return on equity (which gives the maximum possible growth)?

    How much of that growth is put to work through earnings retention (rather than being paid out individends)?

    Growth = ROE x Retention rate

    Also remember ROE is a function of

    Net profit margin

    Total asset turnover

    Financial leverage (total assets/equity)

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    Limitations of Financial Ratios

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    Limitation of Financial Ratios

    Accounting treatments may vary among firms, especially among non-U.S. firms

    Always consider relative financial ratios. They do not make any sense when viewed inisolation

    Firms may have divisions operating in different industries making it difficult to derive industryratios

    Conclusions cannot be made by just looking at only one set of ratios

    Ratios outside an industry range may be cause for concern

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